Written by Darcy D. Moch, Marshall R. Haughey and Jared A. Mackey
The 2019 Canadian federal budget was released on March 19, 2019 (Budget Day). As many of the proposals are aimed at investing in Canada’s middle class, the Budget was relatively light on proposals affecting businesses. Nevertheless, there are a number of measures of relevance to the business community that are summarized below.
Employee Stock Options
Currently, employee stock options may receive beneficial tax treatment that is similar to the taxation of capital gains. Budget 2019 proposes to cap the amount that employees of "large, long-established, mature firms" can claim for the stock option deduction at $200,000 per year (based on the fair market value of the underlying shares at the date of the grant of the stock options). Stock option grants in excess of the annual cap will not receive the benefit of the stock option deduction and will be subject to ordinary marginal tax rates. Employees of start-ups and other emerging Canadian businesses will not be subject to the proposed annual cap.
Further details and proposed legislation are expected to be released in the summer of 2019. Stock options granted prior to the announcement of the proposed legislation will not be subject to the proposed amendment.
Scientific Research and Experimental Development Tax Credits
Budget 2019 proposes amendments to the "scientific research and experimental development" (SRED) program which is generally aimed at encouraging business innovation by providing tax incentives to companies that conduct SRED in Canada. Qualifying expenditures are fully deductible in the year they are incurred and are also eligible for an investment tax credit. While the general tax credit is 15 percent, Canadian controlled private corporations (CCPCs) receive an enhanced 35 percent credit for expenditures up to $3 million. Under current rules, the expenditure limit is gradually phased out where taxable income for the previous year exceeds $500,000 and when taxable capital employed in Canada exceeds $10 million. Budget 2019 proposes to repeal the use of taxable income as a factor in determining the CCPCs annual expenditure limit in order to provide a more predictable phase-out of the enhanced credit.
Accelerated Investment Incentive
Budget 2019 confirms the temporary changes to the capital cost allowance (CCA) rules that the government proposed in the 2018 fall economic statement: immediate expensing for manufacturing and processing investments, immediate expensing for clean energy investments, and the accelerated investment incentive. The accelerated investment incentive provides for an enhanced deduction in the first year of up to three times the normal first-year deduction depending on the type of property and when that property is available for use. These changes aim to encourage investment in Canada and apply to capital property acquired after November 20, 2018, and available for use before 2028.
See our recent blog post on 2018 federal Fall Economic Statement for a full explanation of these changes.
The transfer pricing rules generally operate to ensure that transactions between Canadian taxpayers and non-arm’s length non-residents occur on arm’s length terms. Budget 2019 proposes two measures in respect of transfer pricing.
The first measure is to clarify that the transfer pricing rules take priority over all other provisions in the Income Tax Act (the Act). Currently, both the transfer pricing rules and other provisions of the Act could potentially apply to the same transaction. This has caused some confusion in the tax community as to which rule takes priority in these circumstances. The proposal in Budget 2019 will eliminate this confusion. This proposal will apply to taxation years that begin on or after Budget Day.
The Canadian Revenue Agency (CRA) is generally able to reassess a taxpayer within three years after the end of the taxpayer’s normal reassessment period in respect of transactions involving the taxpayer and a non-arm’s length non-resident person. Budget 2019 proposes to amend this rule to adopt the definition of “transaction” in the transfer pricing rules (which is broader than the ordinary meaning of the term and includes an arrangement or event) so that the extended reassessment period will apply to transfer pricing adjustments. This proposal will apply to taxation years for which the normal reassessment period ends on or after Budget Day.
Foreign Affiliate Dumping
The foreign affiliate dumping rules (FAD rules) generally target so-called “sandwich structures” where a foreign parent corporation controls a corporation resident in Canada (CRIC) which in turn has one or more foreign affiliates. Where this structure exists, investments made by a CRIC in a foreign affiliate can, among other things, result in a dividend deemed to have been paid by the CRIC to the foreign parent which results in Canadian withholding tax. Budget 2019 has expanded the application of the FAD rules so that they apply not only when the CRIC is controlled by a non-resident corporation, but also where it is controlled by a non-resident individual, a non-resident trust, or a group of persons that do not deal with each other at arm’s length, comprising any combination of non-resident corporations, non-resident individuals and non-resident trusts.
Tax Treaty Amendment via Multilateral Instrument
Budget 2019 reaffirms the Government's commitment to continued participation in the OECD base erosion and profit shifting (BEPS) project. It notes that the Government is taking the necessary steps to enact and ratify the recently executed Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) though no indication is provided with respect to timing of the same. The Government is also participating in an OECD review of the standard for individual country reports to ensure that each report provides tax administrations with information that allows for the proper assessment of transfer pricing and other BEPS risks.
BEPS refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. In November 2016, over 100 jurisdictions concluded negotiations on the MLI that will swiftly implement a series of tax treaty measures to update international tax rules and lessen the opportunity for tax avoidance by multinational enterprises. Specifically, the MLI would operate to close the gaps in existing international tax rules by transposing results from the OECD/G20 BEPS initiative into bilateral tax treaties worldwide. The MLI modifies the application of thousands of bilateral tax treaties concluded to eliminate double taxation. It also implements agreed minimum standards to counter treaty abuse and to improve dispute resolution mechanisms while providing flexibility to accommodate specific tax treaty policies.
The introduction, first and second reading of the MLI (Bill C-82) occurred in 2018. The MLI was adopted by the Standing Committee of Finance on February 28, 2019, and presented to the House of Commons on March 1, 2019. The third reading of the MLI at the House of Commons, in addition to the Senate approval process, still remain.
Derivative Forward Agreements—Character Conversion Transactions
Gains realized by taxpayers on the purchase of capital property are taxed as ordinary income when the capital property is acquired under a "derivative forward agreement" (DFA), which is generally defined as an agreement to purchase/sell a capital property if the agreement exceeds 180 days and the difference between the fair market value of the property delivered on the settlement date and the amount paid for the property is derivative in nature. This definition contains a carve out for gains attributable to what the federal government considers ordinary commercial transactions.
Budget 2019 would deny the ordinary commercial transaction carve out where one of the main purposes of a series of transactions or events is to convert interest, dividends, or other income of a trust (excluding capital gains) attributable to a Canadian security of an issuer, into a capital gain. This proposed amendment is set to apply to transactions entered into on or after Budget Day, with grandfathering rules proposed for agreements entered into before Budget Day.
Cross-Border Securities Lending Arrangements
A non-resident that owns shares of a Canadian corporation can enter into a "securities lending arrangement" (SLA) whereby it lends the shares to a Canadian resident and receives dividend compensation payments in respect of dividends paid on the lent shares. The non-resident therefore retains the same economic risks and returns in respect of the lent share, but receives dividend compensation payments from the Canadian resident borrower in lieu of receiving dividends directly. The SLA rules are generally designed to put the non-resident in the same tax position as if the security had not been lent. If the arrangement is "fully collateralized", any dividend as a deemed dividend and subject to Canadian withholding tax. If the arrangement is not "fully collateralized", the payment is treated as interest which generally is not subject to Canadian withholding tax.
Budget 2019 identified concern that non-residents were avoiding the SLA rules by structuring arrangements that either were not "fully collateralized" or did not meet the technical definition of an SLA. It proposes to broaden the scope of the SLA rules to ensure that non-residents cannot avoid withholding tax on dividends from Canadian corporations in these circumstances. The proposed amendments will apply to dividend compensation payments made after Budget Day unless the loan was in place before Budget Day, in which case the amendments will apply to compensation payments made after September 2019.
In addition, the Budget proposes to broaden an existing Canadian dividend withholding tax exemption for SLAs involving shares of foreign corporations. This proposed amendment will apply to compensation payments made on or after Budget Day.
Mutual Fund Trust Allocation to Redeemers Methodology
To prevent double taxation, many mutual fund trusts (MFTs) use what has become known as the "redeemer methodology" to allocate capital gains realized on the disposition of fund assets to unitholders on the redemption of units of such MFT. The MFT then claims a corresponding deduction for the allocated capital gains. Budget 2019 indicates that where the capital gains on the disposition of fund assets exceed the unitholders' gains on redemption, the excess can result in an inappropriate tax deferral. In response, Budget 2019 proposes to introduce a new rule to prevent MFTs from claiming a deduction for the portion of a capital gain allocated in excess of the capital gain realized by a redeeming unitholder if the allocation reduces the unitholder's redemption proceeds.
Similarly, Budget 2019 proposes to introduce a new rule to prevent MFTs from claiming a deduction in respect of ordinary income allocated to a redeeming unitholder if the allocation reduces the unitholder's redemption proceeds. This proposal is aimed at preventing MFTs from using the redeemer methodology to convert ordinary income into capital gains.
Increases in Resources for Audits
In recent years, the Canadian Government has invested significant additional resources in the CRA to expand and improve its audit and enforcement functions. Budget 2019 continued this trend by committing an additional $150.8 million over the next five years to combat tax evasion and aggressive tax avoidance. The CRA will use the funds to hire additional auditors, create a new data quality examination team to ensure proper compliance by non-residents of Canada, and extend programs aimed at combatting offshore non-compliance.